A Moneymagpie reader contacted us about what to do with her pension pot. She said: “I have a few small pensions, probably amounting to about £100,000, and I’m going to have to make some decisions about it in the next year. The problem is, whatever annuity I look at the rates are terrible. What should I do?”
It’s a good question and one a lot of people are asking. For someone approaching retirement there isn’t much to cheer about right now; annuity options look dire, inflation is eating into the spending power of our cash and interest rates on savings accounts are still very, very poor.
So, what do you do? Here are some of the options:
- The problem with annuities
- How to get a better rate if you do take out an annuity
- Is there an alternative to annuities?
- How does income drawdown work?
- What are the benefits of income drawdown?
- What are the risks of income drawdown?
- What else can you do?
By far the biggest problem with an annuity is that you can’t undo your decision. Once you’ve purchased one, there’s no going back. Worryingly, many people still make their decision without taking any advice and without really understanding what they’re buying.
Annuity rates are based on a number of factors including your age, the size of your pension fund and your health. Annuities aren’t an investment – they’re more like an insurance product because the insurer has to decide how long you’re likely to live i.e. how many years they’ll need to pay you an income. Rates are also linked to 15-year gilts or government bonds (which is what insurers use to provide an income to annuity buyers). Sadly for pensioners, these have been at historic lows for some time.
- Today, a 55-year-old in good health with a £100k pension could get an income of £5,165 per year from a level annuity, according to James Robson from independent financial adviser (IFA) Plutus Wealth Management. Back in the 1990s they were nearer 16%.
- Even worse, as inflation rises, your level annuity is worth less and less each year.
- You can buy an annuity that pays an increasing annual income, rising in line with the retail prices index (RPI) in an attempt to maintain spending power, however, the starting payout is much lower and it could take many years to reach the level of a fixed-rate annuity – a 55-year-old would get a paltry £3,250 per year for an annual payment indexed at 3% today.
Pensions expert Dr Ros Altmann has warned that if you bought an annuity at age 65 you’d have to wait until age 82 to get your money back and age 90 before the annuity became ‘good value’.
The number-one rule is to shop around for the best annuity on the market.
In the years leading up to your retirement age, your pension provider will get in touch and prompt you to buy an annuity but never automatically take what’s on offer from your existing pension provider. You could net an extra 31% in retirement income simply by shopping around and picking the best deal. To get an idea of how much variation there is between annuity providers take a look at these example rates from the Association of British Insurers (ABI).
Consider all of the options including joint-life annuities which continue to pay some or all of the income to your partner if you die. Enhanced annuities offer better rates for smokers and people with medical conditions, which can even cover a relatively mild condition such as high blood pressure. There are also investment-linked annuities which carry some potential for income growth (linked to the performance of a with-profits fund). Prudential, LV= and MGM are the main providers but these are fairly complicated vehicles so never take one out without taking professional advice.
Chris Daems of IFA Principal Financial Solutions says: “Ensure that when looking for the best annuity on the market your providers are aware of your health, smoker status and height and weight. It’s possible that you might be a significant boost in your income if your health isn’t tip top, you are a smoker, or you are overweight.”
Yes… something called income drawdown.
Before April 2006 it was mandatory to buy an annuity by age 75 but income drawdown was introduced for people who wanted to delay or avoid purchasing an annuity. Today, you can choose to never get an annuity and stay invested in drawdown indefinitely.
Instead of exchanging your pension pot for a lifetime income, you leave your pension fund invested and draw an income directly from it.
Capped drawdown is the most common type:
- You can take up to 120% of the limit set by the Government Actuary’s Department (GAD) which is reviewed every three years.
- There’s no minimum level so you can leave the fun invested without drawing any income at all if you wish.
- If you die during drawdown the remaining fund is passed on to your heirs.
- At any point you can stop drawdown and buy an annuity.
Flexible drawdown is another type:
- This time there are no limits on the income you can draw.
- However, you must be earning at least £20,000 a year from other pension sources (which includes state pension benefits, salary-related pensions, lifetime annuities and scheme pensions).
You keep ownership and control of your savings, instead of handing that money over to an insurer, while still enjoying the flexibility to take a different course if circumstances change.
You can still take a tax-free cash lump sum of up to 25% of your pension fund if you wish, but you’ll need to transfer the rest to a self-invested personal pension (SIPP) – providers include Selftrade, Hargreaves Lansdown, Standard Life and James Hay.
Not only do you get to keep your money and any dividends or capital rises, but you can also pass on the remaining fund to your heirs if you die, less 55% tax. If you die soon after buying a standard, single-life annuity, your pension fund goes straight into the insurer’s pocket, not to your loved ones.
In the meantime, annuity rates may improve and if your health has deteriorated, you could also get a better income by buying an ‘enhanced’ annuity (designed for people with reduced life expectancy).
The main concern with income drawdown is investment risk – your fund value could fall in value faster than expected and because you’re also taking take an income from your fund, the rest of your money has to work that much harder. On top of this, you’ll have to factor in investment management charges and administration fees for your drawdown plan, both of which could eat into your fund.
There’s also the risk that annuity rates don’t rise in which case you could delay only to find that you have to buy at a lower rate if you do eventually buy an annuity.
For these reasons, income drawdown is generally not recommended for pension funds smaller than £50,000. Some pension providers will only accept funds of £100,000 or more.
Defer your retirement and carry on working
If you continue to work, even on a part-time basis, you take home more of your pay packet because after state pension age you don’t have to worry about National Insurance and after 65 you get a more generous tax allowance.
If you do decide to buy an annuity later on, you should be offered a better rate because you’re older and have a shorter life expectancy. In addition, as people get older they’re more likely to suffer from medical issues which could mean you become eligible for an enhanced annuity.
Boost your state pension
For every five weeks that you defer taking your state pension, your future allowance goes up by 1% and if you put it off by at least a year, you can choose to receive a lump sum instead, made up of the pension you have not drawn plus interest at 2% above the Bank of England base rate. This is a bit of a gamble, but in general the longer you live the more beneficial this becomes.
Find other ways to make and save
Think carefully about how much you’re likely to need in retirement. Remember that some costs will be lower (you don’t have to pay National Insurance) while others may be higher (healthcare, utilities).
If there’s still an income shortfall consider other ways to boost your income. You could rent out a spare room to a lodger for extra cash (you’re allowed to make up to £4,250 a year tax-free under the Rent a Room Scheme), or even downsize your home to release equity (although don’t forget there will be costs associated with selling up and buying somewhere else). Read our money-making ideas for pensioners here.